The New Arthurian Economics

Thursday, March 9, 2017

On the dashboard at the Fed, there is one knob. That knob controls the interest rate.

With investors already banking on the Federal Reserve lifting interest rates next week, attention has shifted to whether the central bank has fallen behind in its quest to keep inflation from rising too quickly.

You could read that a thousand places. Everybody knows interest rates have to go up to prevent inflation. Otherwise, interest rates will be going up to deal with inflation.

Everybody knows it. Nobody has to stop and think about it. And that's a problem, because nobody ever stops to think about other ways we could prevent inflation. There is no second knob.

If you distinguish between "a higher level of debt" and "higher credit growth" you will see that raising interest rates reduces credit growth. But it does not reduce the level of debt.

Higher credit growth is associated with higher GDP growth. So raising interest rates reduces GDP growth. And that's not a good thing.

On any particular day, some people are trying to borrow money while other people are trying to pay down debt. Raising interest rates discourages people who are trying to borrow money. And before long, it can hinder people who are trying to pay down debt. That's not good.

Let's not hinder people. Don't raise rates. Instead, why don't we help the people who are trying to pay down debt? Create some tax breaks to encourage early repayment. I call this idea the Accelerated Repayment Tax, or ART for short. You heard it here first.

Accelerating the repayment of debt is a way to fight inflation.

We need policy to accelerate debt repayment, because we don't pay off debt fast enough. That's how we got into this mess in the first place: too much debt. Accelerated repayment will help us reduce debt. And it is a way to fight inflation.

If we pay off debt fast enough, we don't ever have to have too much debt again. But we do need policy to make it happen. Because everybody wants to get out of debt, and almost nobody can do it. BTW, that's not a character flaw. It is a macroeconomic problem. The whole economy goes bad when there's too much debt. We need policy that will solve this problem.

The Fed needs a dashboard with two knobs: one to control the interest rate, and one to control the acceleration of debt repayment. With those two knobs, policy can fix the economy.

It's not quite so simple, really. Low interest rates are not the only inducement to borrow. Just about every economic package Congress has ever put together is an inducement to borrow, in one form or another. That's the real reason debt grew to such an insane high level. Those policies should be abandoned or, better, turned into policies that encourage repayment of debt rather than maintenance and accumulation of debt. So when I say a second knob on the Fed's dashboard, reality may require a change of thinking in Congress.

But you know, if we have policies that encourage borrowing, and we don't have policies that accelerate the repayment of debt, then our policies are the reason we got into this mess, and the reason we can't get out. It's not a question of bad character. It's a question of bad policy.

There is a simple way out. We need to set the one knob so we use enough credit to keep the economy growing, and set the other knob so we pay off debt fast enough that total private debt gradually declines. If we can get things set up like that, then all we have to do is wait. The economy will get better every day.

Maybe you're thinking that if debt gradually declines, there won't be enough money in the economy. There is a way around that problem. That's what government-issue is for.

The accelerated repayment of debt will reduce the quantity of money created by bank lending. Fed policy, or Federal deficit spending combined with monetization of debt by the Fed, will make up for the loss of bank-issue and assure an adequate supply of money.

Personally, though, I think we have way more Federal debt than we need to make this idea work. This "two knobs" plan is not an excuse for more Federal deficits. It is just a simple adjustment to existing policy.

3 comments:

jim
said...

"you will see that raising interest rates reduces credit growth."

If you actually look at the data you will see just the opposite.

Looking at post-WW2 US economy the period with highest credit growth was 1970-1885 and the period of lowest credit growth was 2008-present. From 1972-1980 total debt expanded 250% or about 12% per year. In the last eight years total debt has expanded about 11%. That's a little more than 1% per year. How can anyone possibly look at the facts and conclude that high interest rates results in low credit growth and low interest rates produces high credit growth? It seems obvious to me that high credit growth is what raises interest rates and low credit growth is what drives interest rates down.

Yeah, Jim, you brought that up the other day when you linked to Richard Werner. He's pretty interesting.

He says if you look at a scatterplot of interest rates versus NPGD the line slopes up to the right: the two series are positively correlated. You are saying the same thing.

I went and started doing graphs right away after I listened to your link. Didn't get anything useful yet. But here's the thing: They raise rates a little at a time until the economy starts to slow down like they want. So... there is a positive correlation until they get the slowdown. And then for a moment, the two series are negatively correlated.

As soon as the economy starts to slow down, they start to bring interest rates down (trying to get that "soft landing"). And while both series are trending down, there is a positive correlation again.

At the bottom, when GDP turns up, there is a brief negative correlation. Then the central bank starts raising rates again. And the correlation goes positive.

Most of the time we see a positive correlation between the two series. But that does not mean that raising interest rates doesn't eventually cause credit growth to slow down.

Also: if the path of interest rates is endogenous, and the Fed simply follows the endogenous path instead of forging the path, it makes no difference. The interest rate paths are the same, and the correlation story is the same.

I didn't say anything about GDP. During the recessions in the 1980s credit expansion was still 10% per year. In what universe is that considered to be slow credit growth?

I disputed the claim that one can "see that raising interest rates reduces credit growth". Where can one see that?

If that statement had any merit at all the period from 1970-1985 would be a period of low credit growth and the period from 2008-present would be a period of high credit growth, but the data shows the exact opposite.